What is Currency Depreciation
Currency depreciation is a fall in the value of a currency in a floating exchange rate system. Currency depreciation can occur due to any number of reasons – economic fundamentals, interest rate differentials, political instability, risk aversion among investors and so on.
Countries with weak economic fundamentals such as chronic current account deficits and high rates of inflation generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But abrupt and sizeable currency depreciation may scare foreign investors who fear the currency may fall further, and lead to them pulling portfolio investments out of the country, putting further downward pressure on the currency.
BREAKING DOWN Currency Depreciation
Easy monetary policy and high inflation are two of the leading causes of currency depreciation. In a low interest-rate environment, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation. While higher inflation is combated with central banks increasing interest rates, too much inflation is seen as a threat to stability, hence the likelihood of currency depreciation.
Additionally, inflation can lead to higher input costs for export which makes a nation's exports less competitive in global markets, which will widen the trade deficit and cause the currency to depreciate.
QE and The Falling USD
In response to the financial crisis, the Federal Reserve embarked on three rounds of Quantitative Easing (QE), which sent bond yields to record lows. Following the first round of QE in 2008, the U.S. dollar depreciated sharply. The U.S. dollar index (USDX) fell by more than 10 percent in the six weeks proceeding the beginning of QE1.
In 2010, when the Fed embarked on QE2 the result was the same. During the 2010-2011 USD depreciation, the greenback hit all-time lows against the Japanese yen, the Canadian dollar and the Australian dollar.
While economic fundamentals in most part determine the value of a currency, political speak can cause a currency to fall.
Throughout the 21st century, the U.S. and China were repeatedly in a battle of words with regards to each others currency value. During the 2016 election campaign, the Republican nominee, Donald Trump vowed to label China a currency manipulator, saying Chinese officials were purposely devaluing its currency, leading to unfair advantages on trade.
Sudden bouts of currency depreciation, especially in emerging markets, inevitably raise the fear of “contagion,” whereby many of these currencies get afflicted by similar investor concerns. There have been a number of such episodes, among the most notable being the Asian crisis of 1997 that was triggered by the devaluation of the Thai baht. In the summer of 2013, the currencies of nations such as India and Indonesia traded sharply lower on concern that the Federal Reserve was poised to wind down its massive bond purchases.